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"Investing in Separate Accounts,", 2002, McGraw-Hill

By Brian O'Connell

Chapter One: They Shoot Mutual Funds, Don't They?

"You behold a range of exhausted volcanoes. Not a flame flickers on a single pallid crest." -- Benjamin Disraeli

Like other monumental cultural trends, it was inevitable.

In the past, generations lived and died in the same society with the same
rules applied through life. Consider the railroad, which replaced the
lumbering Conestoga wagons that transported freight across U.S. prairies. Or how about telegraphs, which originally sprouted along railroad lines? Soon they gave way to the telephone, which in turn is giving way to wireless communication. 

At the end of the 19th century, Americans bore witness to the motorized
automobile. An aberration at first, automobiles soon dotted
newly-constructed urban roads and highways. After a fashion, Americans no longer had a need for a horse and buggy. So it goes with gasoline lamps
giving way to electricity, rail travel giving way to the airplane, and the
typewriter giving way to the personal computer. Good ideas in their day, all
giving way to better ones.

So, it's no surprise that the death of the mutual fund, too, was imminent.
After all, mutual funds couldn't have gone on forever, could they? Like
other cultural supernovas like the steam engine, the horse and buggy, and
the typewriter, mutual funds had to give way to a better idea. With the
separately managed investment account, so they have.

Ascent -- and Decline -- of Funds

Before we talk about Wall Street's transition from the mutual fund to the
separate account -- which is what we'll spend the bulk of this book talking
about -- let's give credit where credit is due. Mutual funds made history.
Their impact on everyday peoples' lives was huge. Most Americans under 50 years of age grew up investing in mutual funds. Most Americans over 50 years of age used them to retire comfortably.

How did mutual funds become such a force, both on Wall Street and Main
Street? And why is that force waning? Let's have a look:

Founded in 1940, mutual funds gave average Americans the opportunity to
invest like professionals. For a fee, investors could hire huge fund firms,
with scores of savvy money managers, to invest their savings in pools of
stocks called mutual funds. For the average working American, mutual funds were manna from Heaven -- an opportunity to have their portfolios managed by the nation's best and brightest financial minds at a price they could afford. 

With the introduction of the 401(k) plan in the early 1980's, mutual funds
really took off. Fund companies, both of the boutique and behemoth variety,
plastered advertisements in newspapers and magazine, and on television and radio. Each promised the best results -- if only you invested your money with them

As the bull market of the 1980's and 90's barreled along, investors enjoyed
the ride. But soon, as their portfolios mushroomed into six, and sometimes
even seven, figures, investors began to grow weary of the tax inefficiency,
out-of-control management, rising costs and underperformance of their mutual funds. With the evolution of the Internet, which gave investors greater access to financial information than ever before, fund shareholders began exploring alternative investment options, like online discount brokerage trading and online banking programs. Soon, the idea of taking greater control over their financial destinies grew more appealing. Emboldened by their Web experience, newly-empowered investors began taking their business elsewhere, both on and off-line. Financial advisors became prevalent, online trading became more commonplace. From there, it was a short leap to separate accounts, individually managed investment accounts that gave investors more control over their investment portfolios at a lower cost, and with greater tax benefits. Separate accounts require investors to pay one flat fee for asset management, a fee much lower than the commissions charged by mutual fund companies. At annual growth rates of over 3' percent each year from 1995 to 1999, separate accounts became the hottest investment tool anywhere. So hot, in fact, that Boston-based Cerulli Associates notes that separate account assets have
risen to over $719 billion at the end of 2000, up from $300 billion in 1995.
Meanwhile, interest in mutual funds began to wane. Sure, mutual funds still
control in excess of $7 trillion through late 2000, with 83 million Americans participating. But distributions to funds slowed and withdrawals increased. 

Soon the mass media began to catch on. According to an article entitled "The Death of Mutual Funds" that appeared in the September, 2000 of Red Herring, "the open-end mutual fund -- still the bastion of popular investing in
America -- came under heavy fire from a slew of competing investment
vehicles like separate accounts that feature cost savings, tax efficiency,
transparency, and customization. Ironically, those elements, now the seeds of the industry's decline, are the same ones that helped it blossom in the first place."

The fault, the article said, could be traced directly back to the
increasingly flaccid mutual fund sector. "The industry, however, has no one
to blame but itself for its imminent fall from favor," said Red Herring.
"Most fund companies do business today very much the same way they did ten years ago, practically ignoring -- and therefore not sharing with their
investors -- the many benefits that technology now offers."

As evidence that the fund industry's slide may not be temporary, but
"lethal" as Red Herring says, the article cites steadily declining contributions to mutual funds in recent years. Despite a fifth knock-out
year in a row for the stock market and an apparent snapback in fund
performance, people are putting far fewer dollars into mutual funds than they did a few years ago. Sure the numbers are huge--equity funds took in an estimated $170 billion last year. But that's 30% below that of two years
ago. 

During 1999's bull market, for example, net contributions to mutual funds
declined 30 percent from the previous year. "Making matters worse, according to the Investment Company Institute (ICI), the industry's trade association, fund redemption rates -- the amount of money investors take out of funds -- increased constantly over the five year period from 1995 through 2000, reaching 24.1 percent in January 2000, from 16.1 percent in 1995," says the article." Extrapolate that level of decline, and equity mutual funds could be experiencing net redemption as early as 2002.

Who would've though that 10 years ago? Back then, mutual funds were still
riding high. In fact, next to the personal computer, a good argument can be made that the mutual fund was the single most powerful commodity in the world during the second half of the 20th century.

That's why it's so sad to bid mutual funds good-bye.

Like most aging monoliths, cracks in the façade are showing. Erosion around the edges is becoming only too apparent. And, thanks to the Internet, which has leveled the playing field to the point where retail investors have as much access to good investment information as do professional investors, Americans are beginning to take a darker view of the venerable mutual fund.

Where's the Beef?

Given recent net contribution and redemption figures like the ones cited in
the Red Herring article, mutual funds appear to be in big trouble. But those
aren't the only reasons. Let's examine a few more:

Choice: While Americans have poured trillions of dollars into mutual funds
in recent Decades, they've done so primarily because they didn't have any other choice. Until recently, the only way small investors could afford a
diversified portfolio of stocks or a professional money manager was to pool
their money with others in a fund.

But with a rise in investor income levels, thanks primarily to the
long-running bull market, the stakes have become higher for Americans. Aside from the individually managed flavor of separate accounts, they also fall easily into the budgets of a burgeoning number of American investors.

Taxes: Imagine a nascent mutual fund investor; say a 28-year-old systems
analyst opening her year-end mutual fund statement for the first time. Now
imagine the sticker shock when she finds out her year-end fund tax bill
reaches $900 -- even though she has never sold a single share of her fund.

Chances are, that's because a new manager came in and sold many of the
fund's holdings, triggering the tax bill. Yep, those capital- gains distributions can be a killer -- Ignites.com, a Web-based fund tracking newsletter, says that, on average, taxes cost fund investors 2.3 percent annually ­ which can be well over ten percent of their average total returns.

When our investor wakes up, she'll recognize something that investment
professionals have know for a long time: open-end mutual funds are often tax inefficient. Long-term shareholders expecting to profit from the benefits of a lower capital gain tax bracket (20 percent) for holdings kept more than a year might be surprised to see a large tax bill when April arrives. Worse,
investors might actually have to pay capital gains taxes even if the fund
posts overall losses. That happens because investors have no control over
what and how often their fund managers are buying or selling, regardless of
how long they hold the fund.

In a Business Week article entitled "Mutual Funds: What's Wrong?" dated
January 24, 2000, the article argues that mutual funds have no choice about distributing their gains, but critics argue they don't do enough to lower them. One way is through better bookkeeping. Just as a tax-savvy investor would reduce the size of a profitable block of stock by selling his
highest-cost shares, fund companies need to do the same. "Yet not all funds follow the "highest in, first out'' accounting. They should. Joel S.
Dickson, a tax specialist at Vanguard, says studies show that HIFO
accounting can save shareholders as much as 1% a year in costs," reports
Business Week.

Another way to cut the tax bill is to trade less often. "The average equity
fund has a turnover rate of 90%, which means that a $1 billion fund does
about $900 million worth of trades each year. Besides triggering gains,
trading incurs commission costs of about 5 cents a share--that's much higher than most individuals pay for online brokerage," says Business Week. Why so high? In part, by paying higher commissions, investment management companies can also use some of the commission--called "soft dollars''--to pay for research, data services, or even newspapers and magazines. "Think of it this way: It's sort of like frequent-flier miles for the fund managers, except they use the shareholders' money," the article concludes.

Tax woes are particularly hard on more affluent fund investors. One reason
is that mutual fund managers typically focus on overall fund performance (a
strategy that may not be in alignment with an individual investor's tax
circumstances). Effective tax planning will include timing security sales to
utilize capital losses or to defer the realization of capital gains. Before
acquiring a particular mutual fund, investors should recognize that mutual
funds generally do not provide the same tax-planning flexibility as do
separately managed accounts.

Another reason is that if an affluent investor holds shares in a mutual fund
that has significant unrealized gains within its portfolio, he or she may
incur an accelerated income tax liability. A mutual fund with significant
unrealized gains has embedded income tax liabilities that are generally
borne by each of the fund's shareholders once the gains are realized by the
fund - despite the fact that not all shareholders will benefit from the
capital gain. In an extreme instance, an investor who purchases shares of a
fund with an imbedded income tax liability could incur a significant income
tax liability as a result - even though the fund has not appreciated in
value subsequent to the purchase. Determining whether a fund has significant unrealized capital gains before making an investment is especially critical for investors with more of their hard-earned cash invested in the fund.

Fund Costs: Fund costs hardly mattered when returns were in the double
digits all those years. But when the Dow has tumbled more than 10 percent in 1999 and 2000, and with the tech-heavy Nasdaq tanking during 2000, investors may be taking a longer look at fund fees. The April, 1998 edition of Money Magazine reports that the average stock fund has an expense ratio of 1.41 percent of assets and incurs annual trading costs of 1.39 percent. That means investors pay roughly 2.8 percent annually, on average, for the "convenience" of investing in a mutual fund.

Traditionally, when it comes to lowering fund costs, mutual fund firms have
long sported a tin ear. Apart from the introduction of index mutual funds in
1976 by John Bogle, legendary founder of the Vanguard Group and father of
low-cost investing, money managers have done little, if anything, to trim
costs for fund investors. In fact, while the rest of the investment industry
is moving toward lower costs, mutual fund companies are raising them.
According to Morningstar, average annual equity fund expenses have risen to 1.55 percent of invested assets through June, 2000. The fact that most of those increases are usually used to fatten the paycheck of the mutual fund managers is a real slap in the face of fund investors.

There used to be a time when mutual funds were the cheapest way for the
average American to enter the equity market. That's no longer true. The
costs of setting up a stock portfolio, so prohibitive in the not-so-distant
past, have dropped dramatically as the Internet has triggered economies of
scale that allow online brokerages to charge transaction fees as low as $8 a trade. Some Web sites are even offering commission-free trades based on an advertising-sponsored model. In addition, most financial Web sites are giving away news, portfolio tracking, equity research, and real-time stock quotes, bringing the price of retrieving information down to, well, zero.

Another reason for rising expense ratios is 12(b)-1 fees. These fees, which
show up in the expense ratio, pay for the fund's advertising or distribution
costs or to compensate those who sell the fund. 12(b)-1 fees can be as
little as 0.25% or as high as 1% per year--and they come right out of the
fund's assets. 

Market Impact: Commissions are not the only costs involved in
trading--there's also what is commonly called "market impact cost,'' an
additional cost incurred when the fund's buy or sell order itself changes
the price of the stock. For example, if a mutual fund wants to sell a large
block of stock, it may have to accept a lower price in order to do the
trade. Likewise, if the fund is shopping for a large block of shares, it
will have to pay more for it.

According to the Business Week article, market impact cost is not something you find in a fund's financial statement. But it can be detected through analysis of the trading records. The cost to shareholders can be high--1% to 5% a year, depending on the size and liquidity of the stocks that a fund trades and the style of trading. Funds that invest in small-cap stocks have higher impact costs than those that buy large-caps, says Nicolo Torre, a managing director at BARRA Inc., an investment consulting firm. And funds that practice a momentum strategy--buying what's hot--usually end up paying more than value investors that buy and hold. The only way to cut market impact costs, he says, is through fewer trades. "Ten percent of the trades reflect 90% of the market impact cost,'' Torre tells Business Week. "Halve the number of trades, and you can significantly lower the fund's market impact cost.'' 


Disclosure Limits: You wouldn't buy a new car without getting in and driving
it -- at least you shouldn't -- but mutual fund companies don't want you to
even look under hood, let alone take a test drive.

According to Securities and Exchange Commission rules, mutual fund companies have to disclose their holdings at least twice a year. Quite a few don't go beyond the bare minimum requirement. That means the information you see when you check your favorite fund's top holdings on the Web is outdated, to say the least. In fact, given the high speed at which managers are changing their portfolios these days, it could be flat-out wrong. According to Morningstar, the typical turnover on a stock portfolio today is in excess of 90 percent a year, which implies that the average fund manager is buying stocks with a 12- to 15-month time horizon.

Fund companies are also beginning to relay more on "window dressing." In the Red Herring article "Death of Mutual Funds, the author says that window dressing is a "common industry trick" that allows fund managers to spruce up their portfolios by purchasing some of the best-performing stocks in a given period shortly before releasing their holdings to the SEC. "By doing so," says the article, "the portfolio will look pretty good to investors' eyes, even though the fund may have missed out on most, if not all, of the run-up in those top-performing stocks it now holds. The practice is legal, albeit sleazy. The saddest part is that there's no practical way to know for sure which funds are doing it and which are not."


Fund Performance: Funds could win back investors if they improved their
returns. Sure, from 1995 through 1999 ­ before the market began to decline-- the average fund earned 19 percent a year, a rate at which $10,000 grows into nearly $24,000. But relative to the Standard & Poor's 500-stock-index funds, which don't pick stocks but just buy those in the index, that's woeful. An index-fund investor would have $35,000--a 28.5 percent compounded average annual return. In all, just seven percent of all equity funds beat the S&P over the same time period. Even subtracting foreign and specialty funds, the numbers don't get much better. Just 15 percent of U.S. diversified funds beat the index.

Too Many Funds: Another way to improve returns is to shut a fund's doors to new investors before it gets too large to manage effectively. This is
especially critical for funds investing in small companies, where too much
money crimps returns. At what point does size start to slow the fund? It
could be as little as $100 million or $200 million for small-cap funds and
several billion dollars for large-cap.

Many funds need to close down--period. John Rekenthaler, research director for Morningstar, estimates that at least half of all equity funds are below $50 million in assets, probably not profitable for their sponsors, and with little likelihood of ever getting much bigger. Liquidating or merging them would go a long way toward cleaning up the clutter of funds that daze and confuse prospective investors and would lower overhead for the firms.
That would give fund companies latitude to lower expenses for shareholders, who by and large haven't benefited much from the economies of scale that go with the sixfold increase in assets over the past decade. As we said earlier, the average expense ratio for equity funds is 1.55 percent, up from 1.45 percent a decade ago. Bond fund expenses have shot up, too, from 0.84 percent to 1.08 percent.


Gone In 60 Seconds: Mutual funds have also become more sensitive in recent years to traders who dart in and out of the funds. In some cases, the
traders have been booted out, and in others, redemption fees have been
instituted to discourage short-term switching. Industry wide, redemption
rates are on the rise.

Slowing down the trading would also enable funds to be more fully invested
and keep less cash in the till for redemptions. That cash is a drag on
performance, since it earns less than it would if it were invested in stocks. Over the long haul, lower cash levels should improve returns.

The World Wide Web: Another serious problem facing mutual funds is that they don't translate well in the Internet era. The technology of funds is so
archaic that investors can do little more with funds on the web other than
check daily prices, buy and sell. Basically, that's the same thing as E-Bay
does with Beanie Babies and other collectibles. Fund investors can't,
however, do meaningful things such as take tax control, screen individual
holdings, or even find out what stocks are in the fund on a real-time basis.
In fact, end users even can't determine the price of the fund shares until
after the market has closed for the day.

A study by Cerulli Associates estimated that 107 million U.S. households
will have Internet access by 2003, versus 34 million in 1999. The survey
showed a large correlation between the adoption of the Internet and the
recent spectacular growth in the number of brokerage accounts. "Based on
historical growth prior to the advent of the Internet," the report indicates, "we believe discount brokerages would have accumulated 12 million accounts by 1999, versus the 20.8 million that existed at last year's end." Those brokerages are bringing investors one step closer to cheaper
investment alternatives and one step further away from the clutches of the
mutual fund industry.

If You Can't Beat'em, Join'em: Fund companies are beginning to take to
separate accounts in a big way. AIM Management Group's nascent managed accounts division recently closed a first deal with First Union Securities under its new subsidiary, AIM Private Asset Management to provide separately managed accounts from a mutual fund company. AIM portfolios became available through First Union's separate accounts Master's Program in October, 2000. AIM initially offered three of its own fund styles--core large-cap, blue-chip and mid-cap equity through First Union. In addition, the new AIM subsidiary signed on futurist Harry Dent, president of HS Dent Advisors, to manage a version of the Dent Demographics portfolio for private accounts.

At New York City-based The Dreyfus Corporation and its subsidiary, Dreyfus Service Corporation, company executives followed suit. A new separate account service that provides individually managed portfolios and related investment services through institutional channels such as broker-dealers or financial planners was rolled out in late 2000.

The Dreyfus separate account team includes a product management team, a client service team and a sales force which work directly with investment
consultants to distribute Dreyfus investment management services.

They're not alone. Fidelity, Massachusetts Financial Services, and
Oppenheimer Funds, among others, are all opening managed account divisions. The question is, are they simply hedging their bets? Or are they opening their main profit centers of the year 2010?

A Word on Mutual Fund "Wrap"

As you delve deeper into the separate accounts world, you're bound to run
into mutual fund wrap accounts. Although not as old as separate accounts,
wrap accounts grew from unsteady beginnings in the 1980's when financial
giants like Fidelity and Smith Barney to develop new fund profit centers in
the burgeoning "fee-only" marketplace.

Cerulli Associates describes mutual fund wrap accounts as programs that are designed to systematically allocate investors' assets across a wide range of mutual funds. Services include client profiling and account monitoring and portfolio rebalancing. An asset-based fee of around 1.25 percent is charged instead of a commission plus the cost of the funds used. Account minimums typically range between $10,000 and $50,000.

Aside from the absence of having a fund manager on board to choose stocks, the primary difference between mutual fund wraps and separate accounts is that, with separate accounts, taxes aren't as big an issue and investors have greater control over their accounts than mutual fund wrap investors do.

Overall, separate accounts are proving more popular than mutual fund wraps, as well. According to Cerulli Associates, separate account assets reached $636 billion in Q4, 2000. Mutual fund wraps have grown at a slower ­ and lower ­ rate. Cerulli reports that mutual fund wraps grew from $109 billion in 1999 to $289 billion through Q4, 2000.

A New Era

The steadily increasing success of separate accounts notwithstanding, the
mutual-fund industry, which controls more than $7 trillion in equity, bond,
and money-market funds, is in no immediate danger of withering away. Funds still meet the needs of millions with no interest in online trading or only modest sums to invest.

Still, the stocks of mutual-fund companies are underperforming the stock
market, and that's a signal that there are problems in the industry.
"Mutual funds used to be the investment of choice,'' says A. Michael
Lipper, chairman of Lipper Inc., a fund data and research company. "Now,
it's more the investment people use when they have no other choices.''

CHAPTER TEXT END



Sidebar I: Words to Avoid Funds By . . .

Interesting viewpoints on the mutual fund industry, from the cream of the
crop on Wall Street:

"Mutual funds are too expensive, they turn over their portfolios at a far
too high rate, and they are too tax-inefficient," -- John Bogle, founder of
the Vanguard fund group and an outspoken fund industry critic.

"Coupled with a few other trends . . . mutual funds are in big trouble.
The standardized, commodity mutual fund we know today is dying." -- Jamie Punishill, senior analyst of online financial services for Forrester
Research Inc. of Cambridge, Mass. 

"Two years from now, with technology evolving so quickly, the question will be why be in a pooled product at all," -- Leonard Reinhardt, CEO of Lockwood Financial 

"Things have changed. I haven't been asked for a fund recommendation for over a year," -- John Rekenthaler, director of research, Morningstar, Inc., September, 2000

"Investors are confused. There are too many funds.'' -- Lawrence J.
Lasser, CEO of Putnam Investments Inc. 

''When you get those 1099s every January, it seems like you're getting hit with taxes on money you never see,'' Moritza Day, CPA and president of Houston-based financial headhunting firm Day West & Associates 

"Fund companies have charged a lot more than they need to cover their costs," -- Robert DiStefano, managing director of information technology at Vanguard Funds


Sidebar II: Expensive Expenses

According to Lipper Analytical Services, which tracks these sorts of things,
the average U.S. stock fund charges 1.43 percent of its assets per year for
expenses.

While that's just $29 per year for a $2,000 account, it's a whopping $1,430
per year for a $100,000 account.

Sidebar III: Waterlogged Inflows

According to the May, 2000 edition of Institutional Investor, by way of
Financial Research Co., mutual fund inflows from $18 billion per month in 1998 to $12 billion in 1999. 53 percent of all fund companies experienced net outflows for 1999.

New mutual funds also fell from 1998 to 1999, the magazine reports, from 718 to 420

Sidebar IV: Too Many Stocks Spoil the Broth

According to the fall, 1997 edition of the CFA Digest, mutual fund companies are overdoing it when it comes to diversification.

The magazine says that the majority of a portfolio's non-systematic, or
diversifiable, risk can be eliminated at portfolio sizes, with holdings of
20 stocks a common occurrence (although holdings of 100 stocks are out there, too). The average growth mutual fund (at the time) hold 78
securities, the magazine reports, thereby limiting any diversification
potential

CHAPTER END